REG, Regulation

Sources for Partnerships: Basis, Allocations, and Distributions

Last reviewed 2026-10-08

The standards and authorities behind PocketCPA's REG lessons on Partnerships: Basis, Allocations, and Distributions. The topic rests on IRC Subchapter K.

About this topic

A partnership does not pay tax on what it earns. The partners do, each on a share of the result. A partnership is a pass-through: it computes income but pays no entity-level tax, passing items to partners on Schedule K-1. Subchapter K is basis-driven, so tracking the two bases is the whole game.

Nearly every trap in the topic is a question answered with the wrong one of those two views.

Key points

• A partner's outside basis starts with the initial contribution and is adjusted for income, losses, distributions, and share of liabilities.
• Sec. 704(b) requires allocations to have substantial economic effect or follow the partners' interests in the partnership.
• A current distribution reduces basis but does not trigger gain unless cash exceeds the partner's basis.
• A liquidating distribution closes out the partner's interest; the basis of distributed property equals the remaining outside basis.
• Hot assets (unrealized receivables and inventory items) convert capital gain to ordinary income on sale or exchange of a partnership interest.

What the lessons cover

1. Formation and the two bases
2. Allocations under Sec. 704
3. Contributed property under Sec. 704(c)
4. Family partnerships under Sec. 704(e)
5. Timing under Sec. 706: inclusion and the closing year
6. Varying interests under Sec. 706(d)(1): interim closing or proration
7. Sec. 706(d): cash basis items and tiered partnerships
8. Distributions and guaranteed payments
9. Related parties and a partnership: the disallowed loss (Sec. 707(b)(1))
10. Related parties and a partnership: ordinary gain and the ownership count (Sec. 707(b)(2) and (b)(3))
11. The Sec. 754 election
12. Basis, at-risk, and passive: the three loss gates in order
13. Selling an interest, hot assets, and the retiring partner

Authoritative references

Where these rules sit in the Code. Each entry names the provision, then breaks out the subsections that carry separate rules.

• Sec. 721 is formation nonrecognition, and Sec. 722, Sec. 723 and Sec. 1223(2) carry the consequences into basis and holding period.
  • Sec. 721(a) is the nonrecognition rule, with no control requirement.
  • Sec. 721(b) turns it off for gain on a transfer to what would be an investment company under Sec. 351.
  • Sec. 722 and Sec. 723 carry the contributor's adjusted basis to the interest and to the property respectively, each increased by Sec. 721(b) gain.
  • Sec. 1223(2) tacks the holding period.
• Sec. 752 makes liability shifts money movements. The direction of the shift decides which way the money is treated as moving, and every one of these four rules is a deemed transaction rather than an actual one.
  • An increase in a partner's share is a contribution of money (Sec. 752(a)).
  • A decrease is a distribution of money (Sec. 752(b)).
  • A liability to which property is subject is the owner's up to the property's value (Sec. 752(c)).
  • On a sale of an interest, liabilities follow ordinary property rules (Sec. 752(d)).
• Sec. 705(a) rolls basis forward: up for taxable income, tax-exempt income, and excess depletion (Sec. 705(a)(1)); down for Sec. 733 distributions, losses, and nondeductible noncapital expenditures (Sec. 705(a)(2)), never below zero.
• Sec. 702 and Sec. 703 separate the items and fix their character.
  • Sec. 702(a) lists the separately stated items, with the residual at Sec. 702(a)(8).
  • Sec. 702(b) sets character as if realized directly from the partnership's source.
  • Sec. 703(a)(1) requires the separate statement.
  • Sec. 703(a)(2) denies the partnership six deductions, including charitable contributions and the NOL deduction.
• Sec. 704(a) makes the agreement control.
  • Sec. 704(b) reallocates by the partner's interest in the partnership when the agreement is silent, or when the allocation lacks substantial economic effect.
• Sec. 704(c)(1) sends built-in gain and loss on contributed property back to the contributor.
  • Sec. 704(c)(1)(A) shares items on contributed property so as to take account of the variation between basis and value at the time of contribution.
  • Sec. 704(c)(1)(B) recognizes that variation to the contributor on a distribution to another partner within 7 years.
  • Sec. 704(c)(1)(C) confines a built-in loss to the contributor, and treats basis as contribution-date value for the others.
• Sec. 704(d)(1) caps the loss deduction at the adjusted basis of the interest at the end of the partnership year in which the loss occurred, and Sec. 704(d)(2) carries the excess forward.
• Sec. 706(a) bases a partner's Sec. 702 and Sec. 707(c) inclusions on the partnership year ending within or with the partner's year.
  • Sec. 706(b)(1)(B) then sets the partnership's own year in a fixed order: the majority interest taxable year, failing that the taxable year of all the principal partners, failing that the calendar year unless the Secretary by regulations prescribes another period.
  • Sec. 706(b)(1)(C) permits a different year only where the partnership establishes a business purpose to the Secretary's satisfaction, and states that any deferral of income to partners is not a business purpose.
• Sec. 706(c) decides when a partnership year closes. Sec. 706(c)(1) keeps the partnership's own taxable year open through four named events, yielding only on a termination of the partnership and as Sec. 706(c)(2) provides.
  • The death of a partner.
  • The entry of a new partner.
  • The liquidation of a partner's interest.
  • The sale or exchange of an interest.
• Sec. 706(c)(2) then closes the year with respect to one partner rather than for the partnership.
  • Sec. 706(c)(2)(A) closes the year with respect to a partner whose entire interest terminates, whether by death, liquidation, or otherwise.
  • Sec. 706(c)(2)(B) does not close it for a sale of less than the entire interest, or for an interest merely reduced by an entry, a partial liquidation, or a gift.
• Sec. 706(d)(1) requires, on any change in a partner's interest, that each partner's distributive share of any item be determined by a method prescribed by regulations taking account of the varying interests during the year.
  • Sec. 706(d)(2)(A) assigns an allocable cash basis item to each day of the period it is attributable to, and allocates each day by interests at the close of that day.
  • Sec. 706(d)(2)(B) limits the term to interest, taxes, payments for services or for the use of property, and regulatory additions, and only where the partnership uses the cash receipts and disbursements method.
  • Sec. 706(d)(2)(C) sends pre-year portions to the first day, and post-year portions to the last day.
  • Sec. 706(d)(2)(D) reallocates a prior-period deductible portion to the partners of that earlier period and capitalizes the share of anyone who is not a partner on that first day, treated in the manner provided for in Sec. 755.
  • Sec. 706(d)(3) applies the same daily assignment to items of an upper tier partnership attributable to a lower tier partnership.
  • Sec. 706(d)(4) determines the partnership's taxable year for subsection (d) purposes without regard to Sec. 706(c)(2)(A).
• Treas. Reg. Sec. 1.706-4 supplies the method Sec. 706(d)(1) delegates.
  • Paragraph (a)(3)(iii) makes the interim closing method the default, and the proration method available only by agreement of the partners.
  • (a)(3)(vi) through (ix) build segments and proration periods.
  • (b)(1) and (b)(2) except contemporaneous-partner changes and partnerships for which capital is not a material income-producing factor.
  • (c)(1) and (c)(3) set the calendar day, semi-monthly, and monthly conventions, and restrict the last two to interim-closing variations.
  • (e) removes extraordinary items from any proration and allocates them by interests at the time of day they occurred, with a small-item exception in (e)(3)(i).
  • (f) defines the required dated written agreement of the partners.
• Sec. 731 decides what a distribution recognizes.
  • Sec. 731(a)(1) recognizes gain only to the extent money distributed exceeds outside basis immediately before the distribution.
  • Sec. 731(a)(2) recognizes loss only on a liquidating distribution of nothing but money, Sec. 751(c) receivables, and Sec. 751(d) inventory.
  • The flush language of Sec. 731(a) makes both gain or loss from the sale or exchange of the interest, which Sec. 741 makes capital except as Sec. 751 provides.
  • Sec. 731(b) recognizes nothing to the partnership.
  • Sec. 731(c) treats marketable securities as money at fair market value, with three exceptions in Sec. 731(c)(3)(A) and a same-class-and-issuer reduction in Sec. 731(c)(3)(B).
• Sec. 732 sets the distributee's basis, and Sec. 733 then reduces the outside basis.
  • Sec. 732(a)(1) carries over the partnership's basis on a current distribution.
  • Sec. 732(a)(2) caps it at outside basis less money in the same transaction.
  • Sec. 732(b) substitutes outside basis less money in liquidation.
  • Sec. 732(c) allocates hot assets first, then other property, with increases going first to appreciation and decreases first to depreciation.
  • Sec. 732(e) yields to Sec. 751(b).
  • Sec. 733 reduces outside basis, not below zero, by money and by the Sec. 732 basis of distributed property.
• Sec. 735 carries character out of the partnership on a distribution.
  • Sec. 735(a)(1) makes distributed unrealized receivables ordinary with no cutoff.
  • Sec. 735(a)(2) does the same for distributed inventory sold within 5 years.
  • Sec. 735(b) tacks the partnership's holding period otherwise.
• Sec. 736(a) treats liquidating payments as a distributive share if determined with regard to income (Sec. 736(a)(1)) or a Sec. 707(c) guaranteed payment if not (Sec. 736(a)(2)).
  • Sec. 736(b)(1) treats payments for the partner's interest in partnership property as a distribution.
  • Sec. 736(b)(2) excludes amounts paid for Sec. 751(c) receivables and for goodwill absent an agreement provision.
  • Sec. 736(b)(3) applies that exclusion only where capital is not a material income-producing factor and the partner was a general partner.
• Sec. 707(a) and Sec. 707(c) decide when a partner is dealt with as an outsider.
  • Sec. 707(a)(1) treats a partner acting outside the partner capacity as a non-partner.
  • Sec. 707(a)(2)(A) and (a)(2)(B) recharacterize services-plus-distribution and paired-transfer patterns properly seen as a sale.
  • Sec. 707(c) covers guaranteed payments determined without regard to partnership income, treating them as made to a non-partner for Sec. 61(a) and, subject to Sec. 263, Sec. 162(a) purposes.
• Sec. 751 is the hot asset rule.
  • Sec. 751(a) makes the slice of the amount realized attributable to unrealized receivables or inventory items an amount realized from property other than a capital asset.
  • Sec. 751(b) recasts disproportionate distributions of receivables and substantially appreciated inventory as sales, with the 120 percent test at Sec. 751(b)(3)(A).
  • Sec. 751(c) defines unrealized receivables, and extends the term to recapture items for Sec. 751, 731, 732, and 741 but not Sec. 736.
  • Sec. 751(d) defines inventory items, including property that would be inventory in the selling or distributee partner's hands.
• Sec. 754 is the election. It applies to all Sec. 734 distributions and all Sec. 743 transfers for the election year and all subsequent years, and is revocable only as regulations allow.
• Sec. 743(a) bars an adjustment on a transfer absent a Sec. 754 election or a substantial built-in loss.
  • Sec. 743(b)(1) increases and Sec. 743(b)(2) decreases inside basis by the difference between the transferee's interest basis and proportionate share of inside basis, and the flush language confines it "with respect to the transferee partner only".
  • Sec. 743(c) allocates under Sec. 755.
  • Sec. 743(d)(1) defines a substantial built-in loss with two independent 250,000 tests.
• Sec. 734(a) bars an adjustment on a distribution absent a Sec. 754 election or a substantial basis reduction.
  • Sec. 734(b)(1) increases inside basis by Sec. 731(a)(1) gain and by basis lost under Sec. 732(a)(2) or (b).
  • Sec. 734(b)(2) decreases it by Sec. 731(a)(2) loss and by basis gained under Sec. 732(b).
  • Sec. 734(c) allocates under Sec. 755.
  • Sec. 734(d)(1) sets the threshold at 250,000.
• Sec. 465 is the at-risk gate.
  • Sec. 465(a)(1) limits the loss to the amount at risk at the close of the year.
  • Sec. 465(a)(2) carries the excess forward.
  • Sec. 465(b)(1) and (b)(2) count contributions and only personally-liable or outside-pledged borrowings.
  • Sec. 465(b)(3) strips out borrowings from a person with an interest in the activity.
  • Sec. 465(b)(6) treats qualified nonrecourse financing secured by real property as at risk, with a partner's share set under Sec. 752 by Sec. 465(b)(6)(C).
• Sec. 469 is the passive activity gate.
  • Sec. 469(a) disallows the passive activity loss and credit.
  • Sec. 469(b) carries it forward.
  • Sec. 469(c)(1) defines a passive activity as a trade or business in which the taxpayer does not materially participate.
  • Sec. 469(c)(2) includes any rental activity.
  • Sec. 469(g)(1)(A) frees the suspended loss on a fully taxable disposition of the entire interest, with Sec. 469(g)(1)(B) deferring relief on a sale to a person related under Sec. 267(b) or Sec. 707(b)(1).
• Sec. 704(e)(1) includes a donee's distributive share in gross income, with three qualifications.
  • It is excluded to the extent it is determined without allowance of reasonable compensation for services rendered to the partnership by the donor.
  • It is excluded to the extent the portion attributable to donated capital is proportionately greater than the donor's share attributable to the donor's capital.
  • A partner's share is not diminished because of absence due to military service.
• Sec. 704(e)(2) deems an interest purchased by one member of a family from another to be created by gift from the seller, and treats the interest's fair market value as donated capital. It limits "family" to four holders.
  • A spouse.
  • Ancestors.
  • Lineal descendants.
  • Trusts for the primary benefit of those persons.
• Pub. L. 114-74 Sec. 1102(b) made four changes to Sec. 704(e), effective under Pub. L. 114-74 Sec. 1102(c) for partnership taxable years beginning after December 31, 2015.
  • It recaptioned the subsection.
  • It struck the former paragraph (1).
  • It redesignated (2) and (3) as (1) and (2).
  • It substituted "this subsection" for "this section" in the redesignated paragraph (2).
• Pub. L. 114-74 Sec. 1102(a) placed the struck recognition rule in the second sentence of Sec. 761(b), which determines whether a person is a partner with respect to a capital interest in a partnership in which capital is a material income-producing factor without regard to whether the interest was derived by gift.
• Sec. 707(b) is the related-party rule for a partnership.
  • Sec. 707(b)(1) disallows losses on sales or exchanges of property other than an interest in the partnership, directly or indirectly, between a partnership and a person owning more than 50 percent of the capital interest or the profits interest (Sec. 707(b)(1)(A)), or between two partnerships in which the same persons own more than 50 percent of the capital interests or profits interests (Sec. 707(b)(1)(B)).
  • Its closing sentences make Sec. 267(d) applicable to the transferee's subsequent sale as if the loss were disallowed under Sec. 267(a)(1), and treat Sec. 707(b)(1)(B) partnerships as Sec. 267(b) persons for Sec. 267(a)(2) purposes.
  • Sec. 707(b)(2) makes any gain recognized on the same two relationships ordinary income where the property is other than a capital asset as defined in Sec. 1221 in the hands of the transferee.
  • Sec. 707(b)(3) determines that ownership under the constructive-ownership rules of Sec. 267(c) other than paragraph (3).
• Sec. 267(c) attributes ownership, and Sec. 267(d) limits the transferee's later gain.
  • Sec. 267(c)(1) attributes an entity's interest proportionately to its shareholders, partners, or beneficiaries, and Sec. 267(c)(2) attributes a family member's interest.
  • Sec. 267(c)(3) attributes a partner's interest and is the one paragraph Sec. 707(b)(3) omits.
  • Sec. 267(c)(4) defines family as brothers and sisters of the whole or half blood, spouse, ancestors, and lineal descendants.
  • Sec. 267(c)(5) permits re-attribution of an interest attributed under paragraph (1), but bars re-running paragraph (2) or (3) on an interest either of those paragraphs already attributed.
  • Sec. 267(d)(1) recognizes the transferee's later gain only to the extent it exceeds so much of the previously disallowed loss as is properly allocable to the property disposed of.
  • Sec. 267(d)(2) excepts Sec. 1091 wash sales, and Sec. 267(d)(3) excepts losses of a transferor for whom the loss would not have been taken into account in determining a tax imposed under Sec. 1 or Sec. 11 or computed as provided by either.
• Sec. 732(d) is the election a transferee makes where no Sec. 754 election was in place.
  • It permits a partner who acquired an interest by a transfer with respect to which no Sec. 754 election was in effect, and who receives a distribution of property other than money with respect to that interest within 2 years of the transfer, to elect to treat as the adjusted partnership basis of that property the basis it would have if the Sec. 743(b) adjustment were in effect.
  • Its second sentence permits the Secretary by regulations to require that treatment whether or not the distribution is within 2 years, where at the time of the transfer the fair market value of partnership property other than money exceeded 110 percent of its adjusted basis to the partnership.
• Sec. 708(a) treats an existing partnership as continuing if it is not terminated.
  • Sec. 708(b)(2)(A) makes the resulting partnership the continuation of any merging or consolidating partnership whose members own an interest of more than 50 percent in the capital and profits of the resulting partnership.
  • Sec. 708(b)(2)(B) makes the resulting partnerships on a division continuations of the prior partnership, other than any resulting partnership the members of which had an interest of 50 percent or less in the capital and profits of the prior partnership.

How PocketCPA uses these sources

Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.

See also

• Sources for every REG topic
• Free REG sample questions
• The CPA exam glossary